Today, the Commodity Futures Trading Commission (Commission or CFTC) adopts a final rule to amend certain of the Commission’s Part 23 regulations. The Commission introduces updates that underscore the critical importance of capital and reporting rules in maintaining the integrity and stability of swaps markets and broader domestic and global derivatives markets. These regulations aim to mitigate known systemic risk concerns.

These well-tailored regulations update capital requirements and financial reporting obligations for swap dealers (SDs) and major swap participants (MSPs) (Final Rule).[1] The Final Rule ensures compliance with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The Final Rule aligns with the statutory mandate established in the Dodd-Frank Act that requires the Commission to adopt and implement robust capital and reporting requirements in swaps markets. The Final Rule includes several technical corrections improved by consultation with the prudential regulators and the Securities Exchange and Commission (SEC) on the adoption and implementation of the Commission’s capital rules. Consequently, I support the Final Rule.[2]

History of Bank Capital Accords

Many in the derivatives industry are familiar with the term Herstatt risk, which signifies the importance of settlement risk in foreign currency markets. On June 26, 1974, Bankhaus I.D. Herstatt K.G.a.A. (Herstatt), a privately-owned German bank, went bankrupt. This bank failure caused serious disruptions in international currency and banking markets and triggered a number of responses. In particular, at the end of 1974, the central bank Governors of the G-10 countries established the Basel Committee on Banking Supervision (Basel Committee) “to enhance financial stability by improving the quality of banking supervision worldwide, and to serve as a forum for regular cooperation between its member countries on banking supervisory matters.”[3]

The Basel Committee, with a broad membership of banking regulators across the most significant financial markets, established a series of international standards for capital adequacy, commonly known as Basel I, Basel II, and Basel III. The Basel Committee’s efforts to set minimum capital standards through international cooperation among banking supervisors is commendable, and its effectiveness relies upon the implementation of its member regulators.

In July 1988, the first Basel accord, “a capital measurement system commonly referred to as the Basel Capital Accord” (Basel I), was approved.[4] Basel I evolved over time with amendments in 1991 to define the general provisions or loan loss reserves that could be included in the capital adequacy calculation, in 1995 to recognize bilateral netting, and in 1996 to recognize multilateral netting.[5] Basel I sought “to strengthen the stability of the international banking system and to remove a source of competitive inequality arising from differences in national capital requirements” following the Latin American debt crisis in the 1980s.[6]

In June 2004, the Basel Committee released a new capital adequacy framework (Basel II), which replaced Basel I. Basel II was more sensitive in measuring risk exposures than Basel I, and there was tremendous focus on supervisory review as effective disclosure.[7] Basel II, which focused primarily on the banking book was complemented, in 2005, by addressing the treatment of banks' trading books, in 2006 with guidance on information-sharing, and then supervisory cooperation and allocation mechanisms in the context of the advanced approaches for operational risk.[8] The new framework was designed “to improve the way regulatory capital requirements reflect underlying risks and to better address the financial innovation that had occurred in recent years.”[9]

Even before the 2007-2009 global financial crisis, the “need for a fundamental strengthening of the Basel II framework had become apparent”[10] as banks were too leveraged and had inadequate liquidity buffers, poor governance and risk management, and inappropriate incentive structures.[11]

The failures of systemically important financial institutions precipitated the 2007-2009 financial crisis. The U.S. Government Accountability Office found that the 2007-2009 financial crisis may have led to $10 trillion in losses, including large declines in employment and household wealth, reduced tax revenues from lower economic activity, and lost output (value of goods and services).[12]

In December 2010, the Basel Committee introduced new capital and liquidity standards (Basel III) in response to the financial crisis. The Committee subsequently revised these standards. The enhanced Basel framework revises and strengthens the Basel II capital adequacy framework and extends it in several areas. Most of the reforms under Basel III were phased in.

As early as 2011, the Committee focused on improvements in the calculation of capital requirements and adopted a series of post-financial reforms. The final reforms “address shortcomings of the pre-crisis regulatory framework and provide a regulatory foundation for a resilient banking system that supports the real economy.”[13]

U.S. Implementation of Capital Requirements

In July 2023, U.S. bank prudential regulators requested comments on proposed rules to strengthen capital requirements for large banks. Disruption in the banking sector in the first quarter of 2023 underscore the necessity of ensuring the adequacy of capital requirements. As I have previously stated, “the more recent banking failures indicate, weak or inadequate prudential regulations, including capital standards, can have catastrophic systemic risk implications.”[14]

Capital requirements are critical to ensuring the safety and soundness of financial markets.[15] Financial market regulators must address the moral hazard of excessive risk-taking and “ensure the resilience and stability of our financial system.”[16]

CFTC Dodd-Frank Act Capital Adequacy Reforms

The Commission introduced new capital and financial reporting requirements for SDs in 2020, as mandated by the Dodd-Frank Act.[17] Section 4s(e) of the CEA introduced minimum capital requirements for SDs,[18] and Section 4s(f) of the CEA created financial reporting and recordkeeping requirements for all SDs.[19] Bank SDs subject to regulation by a prudential regulator are required to comply with the minimum capital requirements adopted by the applicable prudential regulator, while non-bank SDs and security-based swap dealers not subject to regulation by a prudential regulator are required to meet the minimum capital requirements of the Commission and SEC, respectively. Banking regulators and the SEC have adopted capital rules for swaps and security-based swaps activities.

Given the complexities of our markets, the Commission regulates SDs that may also be regulated by prudential regulators and the SEC. The Commission’s overall capital approach permits SDs to select one of three methods to calculate their capital requirements, as permitted under the rule: the net liquid assets capital approach; the bank-based capital requirements; or the tangible net worth capital approach. The Commission’s capital approach evidences the Commission’s recognition of the complexity and interconnectedness of the derivatives markets.

Final Rule’s Codification of No-Action Letters

The Commission published a Notice of Proposed Rulemaking (Proposed Rule) on January 16, 2024.[20] The comment period for the proposal closed on February 13, 2024, and the Commission received 4 substantive comment letters, all of which expressed general support for the Proposed Rule. Other than two revisions to the timing for the submission of reports, the proposed amendments were adopted as proposed.

My statement in support of the Proposed Rule details the amendments adopted today. The Commission is primarily codifying Interpretive Letter 21-15, which applies to commercial non-bank SDs, and No-Action Letter (NAL) 21-18, which was extended under NAL 23-11 and applies to bank SDs, including non-U.S. bank SDs. The Final Rule, which also addresses several other recommended amendments, is a result of collaboration with the banking regulators and the SEC. The Final Rule aims to harmonize processes, procedures, and forms for financial reports and notifications.

Importantly, the amendments do not change the substantive capital requirements, “which serve as a cushion during times of severe market stress to ensure our registrants’ safety and soundness, protect the financial stability of our financial system, and prevent a run on our financial institutions.”[21] The amendments buttress the financial condition reporting requirements, as the Commission retains “visibility and insight into the business and financial health of our registrants and enables us to require corrective action and prevent a failure of a single entity or group of entities or segment of the derivatives market, which could raise system risk concerns.”[22] These are important policy considerations I mentioned in my statement supporting the Proposed Rule.

Conclusion

It is the Commission’s duty to ensure that the implementation of the capital reforms under the Dodd-Frank Act is effective yet sensible and practical, and the Final Rule does just that. I want to thank the Market Participants Division for the excellent work bringing forth this final rulemaking, in particular Joshua Beale, Jennifer Bauer, Maria Aguilar-Rocha, Andrew Pai, and Christine McKeveny.